5.2 Trade Receivables and Contract Assets
5.2.1 Trade Receivables
Receivables that result from revenue transactions under ASC 606
are subject to the CECL model. ASC 606-10-25-1(e) requires an entity to perform
an evaluation at contract inception to determine whether it is “probable that
the entity will collect substantially all of the consideration to which it will
be entitled” for goods or services transferred to the customer (the
“collectibility threshold”). This evaluation takes into account “the customer’s
ability and intention to pay [the] consideration when it is due.” The purpose of
the assessment is to determine whether there is a substantive transaction
between the entity and the customer, which is a necessary condition for the
contract to be accounted for under ASC 606. Although a customer’s credit risk
associated with trade receivables that will be recorded under a contract with a
customer is considered as part of the collectibility threshold, the entity’s
conclusion that the collectibility threshold is reached does not imply that all
receivables that result from the revenue transaction are collectible. That is,
once a receivable is recorded, it is unlikely that the entity will be able to
assert that there are no expected losses on the trade receivable. The entity
must calculate its expected credit losses to determine whether it should
recognize an impairment loss related to the trade receivable and, if so, in what
amount. The likely result is that an allowance for expected credit losses on
trade receivables will be recorded earlier under a CECL model than it was under
previous accounting requirements.
ASU 2016-13 includes the following example illustrating how an
entity could use a provision matrix to apply the guidance to trade receivables.
ASC 326-20
Example 5:
Estimating Expected Credit Losses for Trade
Receivables Using an Aging Schedule
55-37 This Example illustrates
one way an entity may estimate expected credit losses
for trade receivables using an aging schedule.
55-38 Entity E manufactures and
sells products to a broad range of customers, primarily
retail stores. Customers typically are provided with
payment terms of 90 days with a 2 percent discount if
payments are received within 60 days. Entity E has
tracked historical loss information for its trade
receivables and compiled the following historical credit
loss percentages:
- 0.3 percent for receivables that are current
- 8 percent for receivables that are 1–30 days past due
- 26 percent for receivables that are 31–60 days past due
- 58 percent for receivables that are 61–90 days past due
- 82 percent for receivables that are more than 90 days past due.
55-39 Entity E believes that
this historical loss information is a reasonable base on
which to determine expected credit losses for trade
receivables held at the reporting date because the
composition of the trade receivables at the reporting
date is consistent with that used in developing the
historical credit-loss percentages (that is, the similar
risk characteristics of its customers and its lending
practices have not changed significantly over time).
However, Entity E has determined that the current and
reasonable and supportable forecasted economic
conditions have improved as compared with the economic
conditions included in the historical information.
Specifically, Entity E has observed that unemployment
has decreased as of the current reporting date, and
Entity E expects there will be an additional decrease in
unemployment over the next year. To adjust the
historical loss rates to reflect the effects of those
differences in current conditions and forecasted
changes, Entity E estimates the loss rate to decrease by
approximately 10 percent in each age bucket. Entity E
developed this estimate based on its knowledge of past
experience for which there were similar improvements in
the economy.
55-40 At the reporting date,
Entity E develops the following aging schedule to
estimate expected credit losses.
The example above illustrates that an entity’s use of a
provision matrix to apply the CECL model to trade receivables may not differ
significantly from its previous methods for determining the allowance for
doubtful accounts. However, the example also shows that when using such a
matrix, the entity is required to consider the following:
- Whether expected credit losses should be recognized for trade receivables that are considered “current” (i.e., not past due). In the example above, a historical loss rate of 0.3 percent is applied to the trade receivables that are classified as current.
- When using historical loss rates in a provision matrix, the entity must assess whether and, if so, how the historical loss rates differ from what is currently expected over the life of the trade receivables (on the basis of current conditions and reasonable and supportable forecasts).
Connecting the Dots
Unit of Account
As discussed in Section 3.2, an entity is required to evaluate financial
assets within the scope of the model on a collective (i.e., pool) basis
when assets share similar risk characteristics. If a financial asset’s
risk characteristics are not similar to those of any of the entity’s
other financial assets, the entity would evaluate that asset
individually.
As a result, although an entity may be able to continue using a provision
matrix to estimate credit losses, it may need to apply the matrix to a
more disaggregated level of trade receivables because it is required to
estimate expected credit losses collectively only when assets share
similar risk characteristics. That is, instead of applying a single
provision matrix to all of its trade receivables, the entity may need to
establish pools of such receivables on the basis of risk characteristics
and then apply a provision matrix to each pool.
Although the CECL model requires entities to perform a different
evaluation for trade receivables, we generally do not expect that the impairment
losses recognized on trade receivables under the CECL method will differ
significantly from those that were recognized before the CECL guidance. However,
entities with long-term trade receivables (e.g., those with due dates that
extend beyond one year) may experience more of a change than those with
short-term receivables because entities with long-term receivables may need to
consider additional adjustments to historical loss experience to reflect their
expectations about macroeconomic conditions that could exist past one year.
5.2.1.1 Credit Risk Versus Variable Consideration
ASC 606-10-45-4 states, in part, that “[u]pon initial
recognition of a receivable from a contract with a customer, any difference
between the measurement of the receivable in accordance with Subtopic 326-20
and the corresponding amount of revenue recognized shall be presented as a
credit loss expense.” However, the amount of revenue recognized in a
contract with a customer can change as a result of changes in the
transaction price. This is because the amount of consideration to which an
entity expects to be entitled for promised goods or services that have been
transferred to a customer may vary depending on the occurrence or
nonoccurrence of future events, including potential price concessions that
an entity might grant. That is, an entity may accept (and is expected to
accept) less than the contractually stated amount of consideration in
exchange for promised goods or services. Concessions might be granted as a
result of product obsolescence but might also be granted because of credit
risk assumed by the vendor in the transaction. Consider the example below
reproduced from ASC 606.
ASC 606-10
Example 3 — Implicit Price
Concession
55-102 An entity, a hospital,
provides medical services to an uninsured patient in
the emergency room. The entity has not previously
provided medical services to this patient but is
required by law to provide medical services to all
emergency room patients. Because of the patient’s
condition upon arrival at the hospital, the entity
provides the services immediately and, therefore,
before the entity can determine whether the patient
is committed to perform its obligations under the
contract in exchange for the medical services
provided. Consequently, the contract does not meet
the criteria in paragraph 606-10-25-1, and in
accordance with paragraph 606-10-25-6, the entity
will continue to assess its conclusion based on
updated facts and circumstances.
55-103 After providing
services, the entity obtains additional information
about the patient including a review of the services
provided, standard rates for such services, and the
patient’s ability and intention to pay the entity
for the services provided. During the review, the
entity notes its standard rate for the services
provided in the emergency room is $10,000. The
entity also reviews the patient’s information and to
be consistent with its policies designates the
patient to a customer class based on the entity’s
assessment of the patient’s ability and intention to
pay. The entity determines that the services
provided are not charity care based on the entity’s
internal policy and the patient’s income level. In
addition, the patient does not qualify for
governmental subsidies.
55-104 Before reassessing
whether the criteria in paragraph 606-10-25-1 have
been met, the entity considers paragraphs
606-10-32-2 and 606-10-32-7(b). Although the
standard rate for the services is $10,000 (which may
be the amount invoiced to the patient), the entity
expects to accept a lower amount of consideration in
exchange for the services. Accordingly, the entity
concludes that the transaction price is not $10,000
and, therefore, the promised consideration is
variable. The entity reviews its historical cash
collections from this customer class and other
relevant information about the patient. The entity
estimates the variable consideration and determines
that it expects to be entitled to $1,000.
55-105 In accordance with
paragraph 606-10-25-1(e), the entity evaluates the
patient’s ability and intention to pay (that is, the
credit risk of the patient). On the basis of its
collection history from patients in this customer
class, the entity concludes it is probable that the
entity will collect $1,000 (which is the estimate of
variable consideration). In addition, on the basis
of an assessment of the contract terms and other
facts and circumstances, the entity concludes that
the other criteria in paragraph 606-10-25-1 also are
met. Consequently, the entity accounts for the
contract with the patient in accordance with the
guidance in this Topic.
As noted in the example above, the entity believes that it is probable that
it will collect $1,000 from the patient, which is less than the contractual
price of $10,000. Accordingly, the entity records a receivable of $1,000
when it renders services to the patient. Under ASC 326-20, the entity is
required to evaluate financial assets on a collective (i.e., pool) basis
when assets share similar risk characteristics. Therefore, in this example,
the entity would need to consider its portfolio of similar trade receivables
to determine whether it would have to record an additional allowance. This
is because, although it is probable that the entity will collect $1,000, it
is not certain that the entity will collect $1,000 from all similarly
situated patients. Accordingly, the entity would most likely need to record
an additional allowance for further expected credit losses on the basis of
the expected collections across its portfolio of trade receivables.
Entities will need to use significant judgment in determining whether
recorded receivables are not collectible because the entities have provided
an implicit price concession or because there is incremental credit risk
beyond what was contemplated when the transaction price was established.
This is particularly true of entities in highly regulated industries, such
as health care and consumer energy, which may be required by law to provide
certain goods and services to their customers regardless of the customers’
ability to pay. Therefore, entities will need to evaluate all of the
relevant facts and circumstances of their arrangements to determine whether
they have provided implicit price concessions or whether the anticipated
receipt of less than the total contractual consideration represents
additional credit risk, as a result of which they may be required to record
additional credit losses upon adopting ASC 326-20. These credit losses are
measured on the basis of the losses that would be expected to be incurred
over the entire contractual term (i.e., the period over which the
receivables recorded will be collected).
5.2.1.2 Measuring Expected Credit Losses on Trade Receivables When the Corresponding Revenue Has Not Been Recognized
In limited circumstances, an entity may have an
unconditional right to consideration (i.e., a receivable) before it
transfers goods or services to a customer. In those situations, the
entity would recognize the receivable as well as a contract liability
representing its obligation to transfer goods or services to a customer.
This contract liability is commonly referred to as deferred revenue.
Questions have arisen about whether an entity that is
determining the receivable balance on which to estimate expected credit
losses is allowed to reduce the receivable by the associated contract
liability (i.e., deferred revenue). We generally believe that the entity
should only estimate expected credit losses on receivables for which the
associated revenue has been recognized. This belief is premised on the
fact that the entity does not have credit loss exposure related to goods
or services yet to be transferred because if the customer were to
default before recognizing revenue, the entity could simply no longer
deliver the goods or services and avoid a credit loss. In this case, the
entity could use the deferred revenue balance to reduce or “offset” the
exposure related to the receivable balance for which the estimate of
expected credit losses is being determined.
However, we acknowledge that there may be situations in
which an entity is prohibited from recognizing revenue because of
certain requirements in ASC 606, even though it has transferred the
related goods or services. In this case, it would not be appropriate to
reduce the exposure related to the receivable by some or all of the
deferred revenue recognized by the entity because it has already
delivered the goods or services and therefore cannot reduce its exposure
to credit losses by not performing under the terms of the arrangement.
5.2.1.3 Recognition of Expected Credit Losses on Sales Tax Receivables From Customers
A receivable from a customer that is recognized as part
of a revenue transaction may include an amount collected from the
customer related to a sales tax imposed by a tax authority. The seller
will generally have a corresponding payable for the sales tax amount it
is required to remit to the tax authority. In limited circumstances, the
seller may not be obligated to pay the sales tax amount to the tax
authority if the customer defaults on the receivable.
We believe that if the entity is required to pay the
sales tax amount to a tax authority regardless of whether the customer
defaults on the sales tax receivable, the entity is exposed to credit
losses and an allowance for expected losses should be recognized in
accordance with ASC 326-20. However, if an entity is not obligated to
pay the sales tax amount to the tax authority if the customer defaults
on the receivable, the entity has no exposure to credit losses and would
not be required to recognize an allowance for credit losses.
5.2.2 Contract Assets
Contract assets arise when an entity recognizes revenue but the
entity’s right to consideration depends on something other than the mere passage of
time (e.g., the satisfaction of additional performance obligations in the contract).
Contract assets are commonly referred to as unbilled receivables. ASC 606-10-45-3
states that an entity should assess whether a contract asset is impaired in
accordance with ASC 310 (before the adoption of ASU 2016-13) or ASC 326-20 (after the
adoption of ASU 2016-13). Because the collection of unbilled receivables depends on
something other than just the passage of time (e.g., future performance under the
contract), contract assets may take longer to recover than trade receivables.
Consequently, an entity that has contract asset balances may be more exposed to
expected credit losses for recorded amounts than an entity that has only short-term
trade receivables. If the entity’s policy for determining incurred losses on trade
receivables (e.g., a matrix approach) does not contemplate contract assets, the
entity may need to implement additional policies and procedures to reflect such
assets in its allowance for expected credit losses.
The example below illustrates how a
contract asset is recorded under ASC 606 and is recovered over a contract period.
Example 5-4
On January 1, 20X1, Entity X enters into an
arrangement to license its software to Customer Y for five
years. As part of the arrangement, X also agrees to provide
coterminous postcontract customer support (PCS). In exchange
for the license to X’s software and PCS, Y agrees to pay X
an annual fee of $500, invoiced at the beginning of each
year (total transaction price of $2,500), with payments due
within 60 days of invoice (i.e., 60 days after the first of
each year).
Entity X concludes the following about its
arrangement with Y:
- The promises to deliver the software license and PCS represent distinct performance obligations. Using a stand-alone selling price allocation method, X allocates 60 percent of the total transaction price to the software license and 40 percent to the PCS.
- Entity X’s software is a form of functional intellectual property; therefore, the license grants Y the right to use its intellectual property for the five-year contract term. As a result, X satisfies its performance obligation to transfer the software license at a point in time (i.e., contract inception).
- Entity X’s promise to provide PCS is satisfied over time by using a time-based measure of progress (i.e., ratably over the five-year contract term).
- Entity X concludes that the contract does not contain a significant financing component.2
In accordance with ASC 606, X recognizes
revenue as follows:3
Journal Entry: January 1, 20X1
Each year, X provides PCS under the contract
and bills the customer $500. Of that $500, $300 effectively
is applied against the contract asset recorded when the
license was transferred to the customer while the other $200
is related to PCS provided each year. Consequently, the
contract asset would have a four-year contractual term (the
period over which X will collect the contract asset). Upon
adopting ASU 2016-13, X will need to estimate the losses
that it will incur over the contractual term (i.e., four
years) when determining the loss allowance to record on the
contract asset.
Footnotes
2
Entities may need to apply
significant judgment to determine whether the
transaction price should be adjusted to account
for a significant financing component. See ASC
606-10-32-15 through 32-20 for more
information.
3
For simplicity, only the journal
entries at contract inception and for annual
reporting periods are provided.